Friday, October 30, 2009

The stock market is spooked today, with prices dropping and implied volatility soaring. This is arguably the most significant "panic attack" the market has had since earlier this year. In my informal survey of the news today, I see almost universal concern that the positive GDP report yesterday was just a blip, that the economy remains very weak and vulnerable to another decline. Of 10 stories about the economy, at least 9 look at the numbers and can't find any reason to be hopeful. I think this is an exaggeration, but panic attacks like this are part of any recovery story.

When the market suddenly gets scared, my first reaction is to check the status of the market-based indicators of economic fundamentals to see if anything has changed. I can't find any evidence of deterioration in the numbers. Take this chart, for example, that shows spot commodity prices at their highest level of the year.

Swap spreads (next chart) show absolutely no sign of any increased tensions in the market. In fact, you couldn't ask them to be better-behaved. CMBX and ABX prices are still in a rising trend. Inflation expectations built into TIPS prices are near their highs of the year, suggesting that the bond market isn't worried at all about a deflationary slump. Sep. '10 eurodollar futures are trading at all-time highs, suggesting that the market is not concerned at all about an imminent Fed tightening which might upset the economic applecart.

The dollar is weak, but it hasn't moved much for the past six weeks. Gold hasn't gone anywhere for the past three weeks. Oil is only a few dollars higher than it was last June. The Baltic shipping index is 50% above its average for the past year. Credit spreads are within inches of their lows for the year

15 comments:

Agree. Credit spreads have widened out a little bit but are still incredibly tame by historical standards across the quality spectrum. That to me signals little worry about a resumption of the slowdown. It is interesting to see the 10-year treasury rates down yet breakeven rates staying up. With real rates are up, the market appears more worried monetary policy tightening, which is probably an ill-placed worry currently.

The ratios of personal consumption exp. to gross private domestic investment,net cash flow to GPDI,disposable income to GPDI are so farout of whack. They are at historic highs. It seems like a coil that is getting wound tighter.Businesses will have to start spending (and Hiring).....

The ratios of personal consumption exp. to gross private domestic investment,net cash flow to GPDI,disposable income to GPDI are so farout of whack. They are at historic highs. It seems like a coil that is getting wound tighter.Businesses will have to start spending (and Hiring)....

Disagree. Transfer payments to households have driven PCE / GDP to high levels. The real cash economy driven by employed people is driving PCE / GDP at about 55%. This was 73.6% in 1929, 75% in 1934, 60.7% in 1950, 58.1% in 1960, 55.3% in 1970, and so on.

When you count government as "G" plus transfer payments to individuals, "G" restated is running at 32%+. That has only been higher once in non-wartime years ex WWII, and that was 1975. I think the disturbing trend, when you put things in their proper place, is government consumption economically defined, not personal consumption as defined in the orthodox national income accounting equation.

Here is another ratio...forget government and transfer payments...take private wages and salaries to business fixed investment...the ratio has not been this high since first quarter of 1967....I know there are a lot factors in this relationship but no matter how youslice it businesses have overreacted to the slowdown and will have to make it up.

Brodero,Where do personal current transfer payments go? To the health system, rents, and food. The government is attacking the health system, housing is still working through over-supply (rapidly, though), and food retailers aren't exactly bathing in high returns on capital and I don't know that we need more stores anyway. Ex personal current transfer receipts, PCE / GDP is far, far below historical peaks.

As far as profits / GDP, about 35% or so of the S&P 500's profits are generated abroad and I bet you it's far higher on the margin. What does that 35% have to do with US PCE. The connection is indirect. They're related, but the past ratio and the current ratio bear less and less relation.

DaleW I appreciate your comments and you hit on some of the weaker points to my argument.But....sincethe S&P 500 has a heavy foreign presence then it is way undervaluedcompared to net cash flow.....especially with the S&P 500's ratio to net cash flow...

Do you think the commercial real estate problems may be what the market is anticipating as a much bigger problem than previously thought? I keep hearing my real estate law partners say that banks are "pretending and extending" on their loans and that we are only about 10% through the mess. I wonder if the same people who said the subprime risk was not big enough to sink the economy are those who are saying that commercial real estate is not that big a problem either.

CRE's are definitely a problem butfortunately the LTV's are much lower than the residential...there are 3.5 trillion commercial mortgage loans compared to the 10.4trillion residential mortgage loans.....still what will be interesting is the owner occupied buildings that are making payments but have seen the value of the buildings drop below there loan amount.

Bill: I think the market is definitely concerned about CRE. As brodero points out, however, the problem is much smaller than residential RE. In any event, I think there is a very good chance that the market has already priced in all the losses. CMBX prices are up in recent months, suggesting the market has been much more pessimistic than the reality. Of course we won't know for sure until next year...

Thank you again for a great post. For those of us who are leery of the CRE situation, I was wondering if you could recommend a primer on reading the CMBX & ABX indexes? I followed the links in your post to the markit site, but found much of the information cryptic without some addtional background.

Unfortunately I'm unaware of any primers you might read on this subject. It's pretty arcane, and only a relative handful of institutional investors follow this market. It's not meant for the layman, and so there are no books for the layman. Your best bet would be to go to some of the major banks/brokerage firms that make a market in this stuff, as they are likely to have primers for their institutional clients.